Chapter 26
Problems: Set C
P26-1C San Antonio Inc. manufactures basketballs for the National Basketball Association
(NBA). Fior the first 6 months of 2013, the company reported the following operating results
while operating at 90% of plant capacity.
Make incremental analysis for
special order, and identify nonfinancial factors in decision.
(SO 3)
Amount
Per Unit
Sales
Cost of goods sold
Selling and administrative expenses
$4,500,000
3,600,000
360,000
$50.00
40.00
4.00
Net income
$ 540,000
$ 6.00
Fixed costs for the period were: Cost of goods sold $900,000, and selling and administrative
expenses $225,000.
In July, normally a slack manufacturing month, San Antonio receives a special order for
7,000 basketballs at $35 each from the Italian Basketball Association (IBA). Acceptance of the
order would increase variable selling and administrative expenses $0.50 per unit because of shipping costs but would not increase fixed costs and expenses.
Instructions
(a) Prepare an incremental analysis for the special order.
(b) Should San Antonio Inc. accept the special order?
(c) What is the minimum selling price on the special order to produce net income of $3.00 per
ball?
(d)
What nonfinancial factors should management consider in making its decision?
P26-2C The management of Thorstad Manufacturing Company is trying to decide whether to
continue manufacturing a part or to buy it from an outside supplier. The part, called WISCO, is a
component of the company’s finished product.
The following information was collected from the accounting records and production data
for the year ending December 31, 2012.
1. 8,000 units of WISCO were produced in the Machining Department.
2. Variable manufacturing costs applicable to the production of each WISCO unit were: direct
materials $4.75, direct labor $4.60, indirect labor $0.45, utilities $0.35.
3. Fixed manufacturing costs applicable to the production of WISCO were:
Cost Item
Direct
Allocated
Depreciation
Property taxes
Insurance
$1,600
400
900
$ 900
200
600
$2,900
$1,700
All variable manufacturing and direct fixed costs will be eliminated if WISCO is purchased.
Allocated costs will have to be absorbed by other production departments.
4. The lowest quotation for 8,000 WISCO units from a supplier is $88,000.
5. If WISCO units are purchased, freight and inspection costs would be $0.30 per unit, and receiving costs totaling $750 per year would be incurred by the Machining Department.
Instructions
(a) Prepare an incremental analysis for WISCO.Your analysis should have columns for (1) Make
WISCO, (2) Buy WISCO, and (3) Net Income Increase/Decrease.
(b) Based on your analysis, what decision should management make?
(c) Would the decision be different if Thorstad Company has the opportunity to produce
$8,000 of net income with the facilities currently being used to manufacture WISCO? Show
computations.
(d)
What nonfinancial factors should management consider in making its decision?
Make incremental analysis related to make or buy; consider
opportunity cost, and identify
nonfinancial factors.
(SO 4)
98
Chapter 26 Incremental Analysis and Capital Budgeting
Compute contribution margin,
and prepare incremental analysis concerning elimination of
divisions.
P26-3C San Manufacturing Company has four operating divisions. During the first quarter of
2011, the company reported aggregate income from operations of $155,000 and the divisional results shown below.
Division
(SO 7)
Sales
Cost of goods sold
Selling and administrative expenses
Income (loss) from operations
I
$490,000
300,000
60,000
$130,000
II
$410,000
250,000
80,000
$ 80,000
III
$ 290,000
270,000
35,000
$ (15,000)
IV
$200,000
180,000
60,000
$(40,000)
Analysis reveals the following percentages of variable costs in each division.
Cost of goods sold
Selling and administrative expenses
I
II
III
IV
70%
40
80%
50
75%
60
90%
70
Discontinuance of any division would save 50% of the fixed costs and expenses for that division.
Top management is very concerned about the unprofitable divisions (III and IV). Consensus
is that one or both of the divisions should be discontinued.
Instructions
(a) Compute the contribution margin for Divisions III and IV.
(b) Prepare an incremental analysis concerning the possible discontinuance of (1) Division III
and (2) Division IV. What course of action do you recommend for each division?
(c) Prepare a columnar condensed income statement for San Manufacturing, assuming Division
IV is eliminated. Use the CVP format. Division IV’s unavoidable fixed costs are allocated
equally to the continuing divisions.
(d) Reconcile the total income from operations ($155,000) with the total income from operations without Division IV.
Compute gain or loss, and determine if equipment should be
replaced.
(SO 6)
P26-4C Last year (2011) Cagney Company installed new factory equipment. The owner of the
company, James Cagney, recently returned from an industry equipment exhibition where he
watched computerized equipment demonstrated. He was impressed with the equipment’s speed and
cost efficiency. Upon returning from the exhibition, he asked his purchasing agent to collect price
and operating cost data on the new equipment. In addition, he asked the company’s accountant to
provide him with cost data on the company’s equipment. This information is presented below.
Old Equipment
Purchase price
Estimated salvage value
Estimated useful life
Depreciation method
Annual operating costs
other than depreciation:
Variable
Fixed
New Equipment
$216,000
0
6 years
Straight-line
$260,000
0
5 years
Straight-line
$52,000
30,000
$20,000
8,000
Annual revenues are $360,000, and selling and administrative expenses are $45,000, regardless of which equipment is used. If the old equipment is replaced now, at the beginning of 2012,
Cagney Company will be able to sell it for $40,000.
Compute annual rate of return,
cash payback, and net present
value.
(SO 9, 10)
Instructions
(a) Determine any gain or loss if the old equipment is replaced.
(b) Prepare a 5-year summarized income statement for each of the following assumptions:
(1) The old equipment is retained.
(2) The old equipment is replaced.
(c) Using incremental analysis, determine if the old equipment should be replaced.
(d)
Write a memo to James Cagney explaining why any gain or loss should be ignored
in the decision to replace the old equipment.
P26-5C Pateos Corporation is considering three long-term capital investment proposals. Each
investment has a useful life of 5 years. Relevant data on each project are as follows.
Problems: Set C
Project Red
Project White
Project Blue
Capital investment
Annual net income:
Year 1
2
3
4
5
$160,000
$180,000
$200,000
13,000
13,000
13,000
13,000
13,000
18,000
17,000
16,000
12,000
9,000
27,000
22,000
16,000
13,000
12,000
Total
$ 65,000
$ 72,000
$ 90,000
99
Depreciation is computed by the straight-line method with no salvage value. The company’s cost
of capital is 15%.
Instructions
(a) Compute the annual rate of return for each project. (Round to one decimal.)
(b) Compute the cash payback period for each project. (Round to two decimals.)
(c) Compute the net present value for each project. (Round to nearest dollar.)
(d) Rank the projects on each of the foregoing bases. Which project do you recommend?
P26-6C Lindsay Lohan is an accounting major at a western state university located approximately 60 miles from a major city. Many of the students attending the university are from the
metropolitan area and visit their homes regularly on the weekends. Lindsay, an entrepreneur at
heart, realizes that few good commuting alternatives are available for students doing weekend
travel. She believes that a weekend commuting service could be organized and run profitably
from several suburban and downtown shopping mall locations. Lindsay has gathered the following
investment information.
Compute annual rate of return,
cash payback, and net present
value.
(SO, 9, 10)
1. Six used vans would cost a total of $90,000 to purchase and would have a 3-year useful life
with negligible salvage value. Lindsay plans to use straight-line depreciation.
2. Ten drivers would have to be employed at a total payroll expense of $72,000.
3. Other annual out of pocket expenses associated with running the commuter service would include Gasoline $20,000, Maintenance $2,800, Repairs $3,500, Insurance $3,200, Advertising
$1,500. (Exclude interest expense.)
4. Lindsay has visited several financial institutions to discuss funding for her new venture. The
best interest rate she has been able to negotiate is 10%. Use this rate for cost of capital.
5. Lindsay expects each van to make ten round trips weekly and carry an average of five students each trip. The service is expected to operate 30 weeks each years. Each student will be
charged $15.00 for a round-trip ticket.
Instructions
(a) Determine the annual (1) net income, and (2) net cash flow for the commuter service.
(b) Compute (1) the annual rate of return, and (2) the cash payback period. (Round to two decimals.)
(c) Compute the net present value of the commuter service. (Round to the nearest dollar.)
(d)
What should Lindsay conclude from these computations?
P26-7C Dakota Clinic is considering investing in new heart-monitoring equipment. It has two
options: Option A would have an initial lower cost but would require a significant expenditure for
rebuilding after 4 years. Option B would require no rebuilding expenditure, but its maintenance
costs would be higher. Since the option B machine is of initial higher quality, it is expected to
have a salvage value at the end of its useful life. The following estimates were made of the cash
flows. The company’s cost of capital is 11%.
Initial cost
Net annual cash flows
Cost to rebuild (end of year 4)
Salvage value
Estimated useful life
Option A
Option B
$160,000
$40,000
$60,000
$0
8 years
$227,000
$50,000
$0
$12,000
8 years
Instructions
(a) Compute the (1) net present value and (2) internal rate of return for each option. (Hint: To
solve for internal rate of return, experiment with alternative discount rates to arrive at a net
present value of zero.)
(b) Which option should be accepted?
Compute net present value, and
internal rate of return.
(SO 10)